Rio Tinto – after the dividend cut

Rio Tinto mining at 1,705p, after publication of the annual figures for the year to December 31^st 2015. The final dividend was maintained but a more pragmatic earnings related dividend policy – with a minimum dividend guarantee – comes in, putting a floor under the share price. The shares are lowly valued and therefore look attractive on that basis, for investors looking for long-term value at knock-down prices.

At the end of my note on the Rio Tinto (RIO) production results, which were well received by the market, I was bold enough to say that I did not take a cut in the final dividend in relation to last year for granted. It seemed to me that an examination of the cash and cash flow position of this company made the payment of a final dividend in line with last year’s final dividend payout, a not unreasoned expectation, even though the market was clearly discounting such an event (to judge by the then prospective, estimated dividend yield of 8.8%). The market expectation of a cut was built into the then price of 1,724p.

Some two weeks later, the actual annual financial results of the company to 31st December last year saw the final and annual dividend maintained at the level of the previous year; that is to say a 107.5 cents (the company reports and accounts in dollars) final dividend and an annual dividend of 215 cents. I add that on a share price of 1,705p (last seen), an annual dividend payout of 215 cents (using a currency exchange of 1.446 dollars) produces an historic annual dividend of 8.7%.

If the Rio management did not sever the final dividend, they did at least find a management solution for the future by reserving their position on dividends. That is to say, they adopted a policy to pay dividends this year, which more realistically reflect the earnings of the company. An enterprise that has increased financial gearing (see comments below) will not wish to be paying dividends out of capital or needlessly weakening its internal cash flow position.

They have therefore ditched the progressive dividend policy in favour of a pragmatic dividend policy. Essentially, they undertook to pay a dividend of at least 110 cents in 2016. At the exchange rate quoted above, that would mean a minimum annual dividend yield of 4.45%, which is still an above average dividend yield. On those grounds, the shares may be reliably judged to be a useful and realistically attractive dividend provider. A solid looking floor has been put under the dividend expectation for this year, as a basis on which investors and the market may build their valuations.

To repeat, this is the minimum payout and the eventual annual dividend for next year could be above that, depending on the circumstances and outlook a year ahead – particularly the state and prospect of things this time next year. I think that the best way of looking at it is to say that Rio Tinto ordinary shares at 1,705p realistically offer and annual dividend of at least 4.45% for next year. On that basis, now that we have explicit management guidance, this particular dividend yield now looks a good deal more certain than that of many other shares.

Whilst on the dividend, I point out that the share goes ‘ex- div’ on the 25^th of this month, so that on a share price of 1,705p, I estimate the single payment final dividend yield to be in the region of 4.3%, which is more than the calculated minimum promised dividend yield for the whole of next year. Unless you think that we are witnessing a Rio Tinto and world Götterdämmerung – which I do not – it looks a highly attractive single payment, supported by a further minimum annual yield for this year of 4.45%. If reason and logic have any part to play in this haunted market, then income funds will be buying the shares over the next ten days, before it goes ex-dividend on the on 25^th February.

At that stage I turn to the financial results for last year, which support the view, in my opinion, that these shares in a solid mining business, at this price (1,705p last seen), are an attractive acquisition on a longer term basis.

Although the statutory results included a net loss of 866 million dollars (down from a statutory profit of 6.5 billion dollars a year earlier) operating cash flow was reported as being 9.4 billion dollars with ‘underlying’ earnings of 4.5 billion dollars; which means of course, that the shares are currently selling at about 3.5 times operating cash flow and 7.25 times underlying net income. I add that in EBITDA terms (that is to say profits before interest, taxation, depreciation and amortisation – a key calculation in takeovers and acquisitions, for example) the shares are valued at around only 2.7 times a reported underlying EBITDA figure of 12.6 billion dollars in 2015.

Looking at other items in this set of annual results, CEO Sam Walsh speaks of a strong balance sheet. You should note that balance sheet gearing was reported to have risen from nineteen per cent the year before, to 24% on December 31^st – an increase in borrowing of one twentieth. By way of market guidance, the company added that gearing should fluctuate between twenty per cent and thirty per cent across the cycle, which I take to mean that gearing is likely to move higher before it goes lower.

He also spoke of a deteriorating macroeconomic environment and the company’s response in making further cuts to its cost base. The company speaks of taking decisive action to undertakes further rounds of cost cutting (a further $1 billion out of operating costs; further significant reductions in capital expenditure this year and next; and a reduction in working capital).

I can do no better that quote verbatim what the CEO has to say on that score:

“These significant actions provide us with the confidence that we remain robustly positioned to maintain both balance sheet strength and deliver shareholder returns through the cycle.” 

Although profits and earnings have come down a long way, so has the share price in discounting the aforementioned macroeconomic problems. In the last year, the FTSE 100 Index has fallen nearly nineteen per cent whilst Rio’s share price has slumped by a massive forty two per cent, with much of that occurring in recent months. The share price is now so low that all the benefits that we saw reflected in the earlier higher share price are vanished as in a dream. Over five years the market, in the shape of the FTSE 100 index, is down nine per cent. The Rio share price over that period has collapsed 68%. However, in the last month the share price is actually up a touch, while the FTSE 100 index is down more than five per cent. Is the downward momentum now running out of steam?

The shares are clearly bombed out, like a town in Syria. Market conditions of almost hysterical uncertainty make it difficult to form a positive judgment. But in my experience and lifetime, these are the times which throw up long-term bargains. No one knows the future. But it is in the darkest times that you sow the seeds for the best returns. Rio Tinto has shown itself to be an efficient, well managed, cash generative business. Moreover, when the turn comes, it also has the gearing to take the fullest advantage of it. I judge this equity to be attractive on its own terms.